Clearly, the Reserve Bank of India (RBI) did not learn from the errors that it made last week, when it capped the daily borrowing by banks from its "repo window", or the liquidity adjustment fund as it is formally known, to Rs 75,000 crore - about one per cent of all deposits. It also raised the interest rate on the marginal standing facility, and announced a sale of government securities. All these measures would reduce the supply of rupees. If the RBI's intent was to allow long-term rates stay high while tightening short-term rates - well, it didn't work out that way. But the RBI has now doubled down on this problematic position, by saying banks could only borrow 0.5 per cent of their own deposits from the repo window; naturally, since the earlier limit came to one per cent overall, this will further reduce liquidity, by about a half. In addition, requirements for the cash reserve ratio (CRR) - the amount of money the banks must keep with the RBI - have been altered. Instead of allowing the banks flexibility and calculating CRR over a fortnight, the entire CRR - four per cent - will have to be kept with the RBI every single day. Overall, this can suck about Rs 90,000 crore out of the system.
There is only one consequence of this: banks will be even more reluctant to lend than they have been hitherto. This squeeze on credit will be disastrous for any hope of an investment recovery, and thus a relatively smooth return to higher growth. And what is being purchased at the cost of the India growth story? A dubious, and almost certainly temporary, protection of the exchange rate of the rupee. Making this choice is not only the wrong thing to do, it is also self-defeating. After all, when international investors see that growth will slow thanks to a credit crunch, they will pull money out of the equity markets. Then the rupee will fall further. And if the RBI tries to defend it, then a crisis will be precipitated - as happened with some of the countries in Southeast Asia in the 1990s. In any case, a defence of the rupee will only give foreign institutional investors (FIIs) higher returns as they exit, at the cost of Indian borrowers.
So the message to investors that the RBI has managed to send is: get out while the going is good. Neither credit rating agencies nor FIIs are likely to ignore these signals. Nor is it reassuring for any observers to see the government tackling the symptoms (pressure on the rupee) instead of the cause (a structurally high current account deficit). The market has seen this: even if the rupee has held tight, the forward premiums for buying dollars have exploded upwards to levels last seen in the 1990s. If the government continues to focus on the symptoms, it will send India back to the 1980s - with an overvalued exchange rate, crisis threats, visits to the International Monetary Fund and a thriving illegal business in gold smuggling. True, a weaker rupee would make the government's fiscal deficit worse, since fuel subsidies would cost more - but the answer is for New Delhi to take the correct decisions to cut the deficit, not for it to strangle growth further in co-ordination with the central bank.
